What’s The Right Ratio Between Salary And Distribution To Save On Taxes And Avoid An Audit?

Every year I like to ask my tax accountant: What’s the least amount I can pay myself in salary and bonus before the IRS comes knocking? Every year, he comes up with a slightly different answer because he observes the IRS focus on different type of situations to audit.

You might ask yourself, why I would want to be paid the least amount possible by my business? The answer lies in the self-employment tax (FICA + Medicare). As a S-Corp business owner, I’ve got to pay the employee’s and employer’s portion of the self-employment tax on salary. This equates to a 15.3% tax (12.4% for Social Security tax + 2.9% for Medicare tax = 15.3%). If you’re an employee, you only pay 6.2% Social Security tax and 1.45% tax for Medicare. Spend some time looking at your pay stub next time and marvel!

Social Security taxes are applied to income up to $132,900 for 2019. This income limit goes up by around 2% a year on average.

There is no income limit to the Medicare tax, and there’s actually an extra 0.9% Medicare tax if you make over $200,000. The maximum Social Security tax for a self-employed individual is therefore $20,334 in 219.

Meanwhile, any money left over after operating expenses, retirement contribution, and salary may be paid out in the form of a distribution. Distribution pays 0% self-employment tax.

THE RIGHT RATIO BETWEEN SALARY AND DISTRIBUTION

The ideal tax situation is to pay yourself $0 salary and the remaining balance in distribution. This avoids paying the 15.3% in self-employment taxes. However, you are still liable to pay state income tax, federal income tax, franchise tax, etc. Unfortunately, the IRS wants their self-employment tax money and does not allow such a ratio.

So what’s the right amount of salary to pay? According to the IRS and my accountant, the right amount of salary to pay depends on industry standards. The salary must be a “reasonable amount,” which is open to interpretation. A reasonable amount usually equals the median salary someone would earn doing what you are doing at your firm.

My Example

My company is an online media company and I am the main writer. In San Francisco, the cost to have a writer produce 3-4 quality articles a week is anywhere from $70,000 – $150,000 a year. Therefore, a reasonable salary I could pay myself is somewhere in this range.

But in order to pay this salary range, my company must make at least $70,000 – $150,000 in gross profits! And given you are allowed to pay whatever is left after salary, operating expenses, and retirement contribution in distribution, it’s unreasonable to pay yourself a salary equal to 100% of operating profits given the 15.3% tax.

Most businesses aren’t profitable in their first year of operation. There are startup costs and fixed costs that must be spent. It takes time to generate traffic and revenue. Further, you might be running your business out of a lower cost area like China, where the GDP per capita is around $6,800. Given there is so much subjectivity to what “a reasonable amount” means, the best way to think about how much to pay yourself in salary and distribution is with a ratio + a reasonable explanation.

I’d like to highlight a combination of ratios and reasonable explanations that could work.

Unprofitable Business: No salary or distribution

Profitable Business

Business does not generate enough to pay a reasonable salary: 1:10 up to 1:1. For example, $1,000 salary: $10,000 distribution; up to $5,500 salary:$5,500 distribution.

Business generates enough gross profit to pay a reasonable salary: 1:10 up to 1:1. For example, $200,000 salary:$2,000,000 distribution; up to $1,100,000 salary:$1,100,000 distribution.

Let’s talk about these ratios with reasonable explanations.

High Ratio Of Salary:Distribution: At first glance, many people would find a 1:10 ratio pretty risky. It seems like the self-employed individual is trying to avoid paying the self-employment tax. However, if your total operating income is $11,000, you’re not even making poverty wages. Perhaps your business just got out of being in the red for three years. You pay yourself a token salary of $1,000 because you don’t know at the beginning of the year whether you’ll be profitable. Only until year end do you realize you’ve been able to eek out a profit, and pay yourself $10,000 in distributions.

Now let’s take a look at the business that is just killing it with $2,500,000 in gross profits a year. Paying yourself $200,000 is a top level salary, even for here in the expensive San Francisco Bay Area. Therefore, paying what’s left of operating profits after salary, operating expenses, retirement contribution in the form of a $2,000,000 distribution doesn’t seem that unreasonable. It’s not your fault that your business is so good that it makes so much more moneythan your salary. That’s called leverage.

Finally, let’s say you’re making $100,000 as a freelance physical fitness instructor in addition to your unrelated online media business that generates $500,000 in gross profits a year. Given you already make $100,000 as a freelance physical fitness instructor, and therefore pay the entire self-employment tax of 15.3%, paying yourself $80,000 from your online media business, with $350,00 left in distribution seems reasonable for a 1:4.3 ratio.

The IRS cares about your TOTAL salary, not just salary from your media business. You should get a self-employment tax refund since you paid self-employment tax on $180,000 of income instead of just $132,900.

Low Ratio Of Salary:Distribution: According to my accountant, paying yourself a 1:1 ratio is probably the most efficient and least risky way to go. But again, it depends on your overall operating profits and what a reasonable salary is to do your job, which is subjective. Even a 1:1 ratio is subjective. But my accountant has never heard of someone getting audited for paying themselves a 1:1 ratio.

For example, let’s say your business has gross profits of $100,000 a year. Paying yourself $30,000 in salary and $30,000 in distribution with the remaining cash left with the company sounds reasonable living in an expensive city. If your business had gross profits of $1,000,000, you could pay yourself a salary of $500,000 and distribution of $500,000 too if you have zero operating expenses and don’t play to contribute to a tax advantages retirement account. You’ve already reached the maximum $118,500 salary that faces the 15.3% self-employment tax, so the remaining $381,500 salary is subject to zero self-employment tax.

Most Risky Salary:Distribution Ratio: Paying yourself zero salary and all distribution is obviously the riskiest. My accountant made one of his clients sign a document saying he advised against doing so. This was seven years ago, and this client hasn’t been audited yet, and he distributes $200,000 – $250,000 a year.

Least Risky Salary:Distribution Ratio: Paying yourself 100% in salary is the safest route to go. But you are paying unnecessary taxes since the IRS definitely allows you to pay yourself a distribution. Therefore, it’s up to you to figure out what ratio is best for you.

So long as they get their 15.3% tax on $132,900 worth of salary from you, the IRS should have nothing to complain about if you’re giving yourself a very high distribution amount. They’re just waiting patiently for you to start hiring more employees.

TAXES NEED TO BE PAID

Even though you must pay both sides of the self-employment tax, the upside to being your own boss, besides the amazing freedom and sense of satisfaction you get from creating something from nothing, is you have much more flexibility in deducting expenses, paying yourself in distribution, and contributing more to a self-employed 401k or SEP-IRA.

I can’t tell you what the right amount of salary you should pay yourself. This topic should be discussed with your accountant. The salary just has to be reasonable in the IRS’s eyes. I paid myself too much last year (over $132,900), so I plan to pay myself less this year as soon as my mortgage refinance is done!

Finally, it’s not like your FICA and Medicare taxes will go to waste. You’ll eventually get at least some of your money back, provided you live a long and healthy retirement.

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Author Bio: Sam started Financial Samurai in 2009 to help people achieve financial freedom sooner, rather than later. He spent 13 years working in investment banking, earned his MBA from UC Berkeley, and retired at age 34 in San Francisco.

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Comments

I get why the ambiguity exists (IRS can’t tell you how much to pay yourself) but I think the current methodology, which amounts to “guessing,” doesn’t make much sense either. You pay yourself what is reasonable… OK, but you might get audited if you don’t pay enough. How much is enough? Well……….

When Bargaineering made more than the $118,500, I just paid myself $118,500 to avoid any type of headache. Was I a personal finance writer? Was I an internet marketer? What exactly was my job title? Who knows? But you can be safe that $118,500 will avoid an audit (In five years, I was never audited due to salary).

That’s silly. If you get audited the IRS will want to see how you applied the factors laid out in FS-2008-25, not what you paid yourself because you thought it would result in a no change. You should document the factors either way because that is what they will ask for.

Tim, can you elaborate further on your comment? What more does the IRS want if you are paying yourself the maximum income for maximum self-employment tax? I’m arguing in this article that every business owner of an S Corp needs to have a reasonable explanation for the salary and distribution ratio. Thanks

$118,500 is not the maximum. Remember, there is Medicare tax which has no cap.

Also, in some areas, there is corporate tax on distributions, for ex, in NYC. In NYC, as a result, paying out almost everything in salary may sometimes be better than paying the payroll taxes. You can’t win here!

$118,500 is the maximum income for the Social Security tax for 2016. Feel free to check with your accountant or the IRS’s website here. You are correct in that there is no income cap for Medicare tax, and I’ve clarified it in the post.

As my accountant and attorney always advise me, don’t let the tail wag the dog. I don’t like paying more taxes any more than the next guy, but for me that’s not the only factor. In fact, in addition to taxes, there is the fact that Manhattan is really unaffordable for most of us.

Sorry my point regarding the $118k limit was specifically pertaining to Medicare, which I know you mentioned above but in the comment you mentioned “maximum self-employment tax” and I thought you meant both Medicare and SS. My bad!

The IRS wants you to follow the tax code and the method by which you determine your salary is not the same for all types of corporations. The code you use to determine owner income is a separate part of the code than the S-Corp code, so they look at them independently. If they audited you would likely have a positive change, which is why it is silly you would just pay the max to be conservative, because that number is not based on any facts.

Thanks. Have clarified Medicare tax in the post and included the additional 0.9% Medicare tax for income over $200,000. The Social Security tax maximum remains at $14,694 for 2016, which is what many are shooting to reduce even though we supposedly get the money back in the form of Social Security in the future.

I’ve always found this to be an interesting topic. In my old analyst job, I occasionally would help companies fight the IRS (and the other way around) when it came to “reasonable salary.” Many, many business owners claim a $0 salary and take the rest as distributions, which is just crazy to me.

Figure out how much you need to live per month first, then divide by 2. You can take a distribution up to the amount of your salary any higher and you are asking for trouble. The right salary really is just whatever the dollar amount is so that you can sock away 53000 a year in your solo 401k. Assuming you make that much and dont need to reinvest. I do 4k salary 4k distribution. And then hsa and solo 401k. Salary is technically lower 100s since the hsa 401k and health insurance are all technically salary items that you eventually just write off anyway.

This is the opposite end of the income spectrum from what we’re currently calculating (how to max our Obamacare subsidy and minimize our taxes by living on as little as possible in retirement — but not so little that we have to be on Medicaid). But even right now, while we’re working and in a substantially higher tax bracket, we think hard about that audit chart. It makes my heart sink to see that the audit percent jumps so quickly after $200K. But that and the AMT are why we don’t claim some of the deductions we could legitimately take (example: home office), because to us, they just aren’t worth the red flags they would add to our file, given that we’re already at an elevated audit risk. (Can you tell that I lived through an audit as a child and was scarred by it — that would be my parents who got audited, not me.) :-)

You’re pikers. Depending how much you earn, you should be able to save more than a third on SS taxes, but you need to be a C corp.

1st: Corporate income taxes are 15% on the first 50K in profits. So, make 50K in profits, and pay the rest as a dividend to yourself. If you have no other income, you’ll pay no Federal taxes at all on that income. That’s 42.5k in your pocket. (You can earn 90k in dividends and pay no Federal income tax as a married man. Try it on TurboTax.)

Ah, but you are blessed to have more corporate income than 50K, you say. Time to stop screwing around with Solo 401k and get a REAL retirement plan, a defined benefit pension. You need to get an actuary, but you can throw a LOT of money into the pension annually, and it all goes in from corporate coffers without a dime of tax being paid on it. Oh, and no FICA, either, which is 15.3%. If you’re careful about it, you can dissolve the pension plan and pay it out to the workers, who can roll the money into an IRA. Using substantial periodic payments, you can pay that out without penalty tax, which is only 10%, not 15.3% anyway.

If you’re REALLY bold, you’ll look up subchapter T dividends, and figure out how to avoid double taxation of dividends. But that’s for another time.

Great article, but I’m so confused about something. A few CPA’s have told me that my monthly distribution can’t be an amount that is more than my monthly salary.

For instance, my salary is $2,000 a month after taxes are taken out so they are telling me my monthly distriubition to myself can’t be more than $2,000. WTH??

No one seems to be able to explain to me why this is? Is this even true? For example, if I make about 65,000 net a year and my salary is about 30,000 a year then how much can i take a month for distriubutions?

Also, if you are paying yourself $127,500 in salary… you are paying the FULL FICA tax. Therefore, after you get past $127,500, I think it becomes less of a red flag to pay yourself in distribution b/c it’s taxed the same.

I’ve always planned on the Warren Buffet defense. If the IRS is ok with him getting paid only $100,000 salary, and since I’m probably not quite as good as him, some discount off that seems like a great starting point. :)

This is the most helpful website I have been to this year. Thank you guys! The info here makes one feel like a pro after reading. I just started my business and trying to figure out how much salary to pay myself. I don’t even know how much I will make, I can only estimate.

What about all the corporate executives running multi-billion dollar corporations (Mark Zuckerberg, Elon Musk, Larry Ellison and others) who get paid $1 per year? How/why can they escape employment taxes?

Distributions fall within your federal tax bracket like other income — they are just free of FICA. The new tax laws also provide an extra tax break for pass-through income on certain businesses, which could reduce your taxable income further. I use Gusto for payroll and quarterly taxes as well, but I still have an actual accountant who files my S-Corp taxes each year and is available to answer questions like these. I would strongly suggest talking with an accountant to get proper guidance and answers to your questions now – not next year when it comes time to file.

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